Spread…And More Spread, Please

One topic we discuss internally quite a bit is the idea of “reasonable” return expectations for value-add and opportunistic real estate investments. 

Looking back to the days of 10.0% cap rates and the risk free rate averaging north of 5.0%, the aforementioned return profiles were driven by the infamous 20.0% IRR and 2.0 multiple test. An arguably reasonable spread given the illiquidity premium and leverage risk of a real estate equity position. 

Fast forward to our current environment where the risk free rate has straddled 1.5%-3.0% and cap rates range from sub 4.0%-7.0% depending upon product type. Given this scenario, what is the appropriate risk-adjusted spread for a mezzanine, preferred equity, or joint venture equity investment? Such is the case with the current misaligment between market and capital return expectations. Given the future prospect of a perpetually low interest rate environment, coupled with the impact technology will have toward ever-increasing market transparency, perhaps our return expectations should be re-calibrated to meet a more traditional risk-adjusted spread.   
Dave Kidder
President and Managing Director